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For what it's worth, my exchange rate toy (MERT) predicts the value of the CDN$ to be 98.96 cents U.S. It's currently at 98.34 cents. Given that interest rates are likely to go up first in Canada (rather than the U.S.), the Canadian dollar is *undervalued* given current oil prices.

Interesting. Do you remember offhand what your model was saying in October? Was it saying that it was overvalued?

"Interesting. Do you remember offhand what your model was saying in October? Was it saying that it was overvalued?"

Good question - I honestly can't remember. The data is easy enough to come by, though. Predicted vs. Actual in 2009 would make for an interesting blog post.

Thanks for the post Stephen, relating the inflation data to the exchange rate vs interest rates is very interesting.

I want to quibble with the commodities story you've presented. While clearly CAD/USD is correlated to the price of commodities, I'm not so sure that this is because of Canadian dollar strength, as compared to US dollar weakness.

If the increase in the price of commodities was related to increased strength in CAD, then it should be evident if one looks at other CAD/XXX currency pairs, such as the CAD/Euro exchange rate (particularly as Euro-land is a net exporter of commodities (or at least oil). I have a chart comparing CAD/Euro to both crude oil prices and the Dow Jones Commodity Index here http://special----k.blogspot.com/2010/03/is-canadian-dollar-driven-by-price-of.html. If you take a look, you'll note that there is no consistent correlation between crude oil prices and CAD/Euro (nor between commodity prices and CAD/Euro).

To me this suggests that the relationship between commodity prices and CAD/USD is driven by USD, that is USD weakness increases both the price of commodities and CAD/USD in a proportionate manner (and keeps CAD/EUR relatively constant).

This also suggests that looking at the relationship between commodity prices and CAD/USD doesn't add a lot of extra information to the CAD/USD exchange rate. Rather it might be more informative to look at the US dollar index instead.

On the other hand, and related to Nick's point, if an increase in the exchange rate is to take the place of an increase in interest rates, does it matter if CAD strengthens or USD weakens? Maybe not to Canada, but it might to the US?

I think Kosta is right. The chart just correlates weakness in the US dollar to weakness in the US dollar. And when you try to correct for this, the correlation between the CAD and oil prices will be close to non-existent.

A while ago I tried the same exercise with the Swedish Krona and Norwegian Krone. Norway a huge oil exporter, Sweden an importer. Should be like US/Canada, right? According to theory, the Norwegian Krone has got to be a petrol dollar. But no, there is no correlation whatsoever of SEK/NOK to oil prices. Nor is there a correlation between EUR/NOK and oil. After seeing that I stopped using commodity prices to understand x-rates. Fine in theory, bad in practice.

I've been using commodity prices as a proxy for the terms of trade. The fit is pretty good.

I have to agree with Stephen that commodity prices appear closely correlated to the terms of trade. That certainly applies to the past decade as Stephen's graph dramatically illustrates.

Wait till base metal prices firm up a bit more. The flow of foreigners lending money to Canadian-based operations will increase dramatically. (As an aside, it might be an opportune time to start shifting retirement savings into US equity.)

Incidentally, some pundits are predicting that the BoC will raise overnight rates before the US federal reserve raises federal fund rates.

While clearly CAD/USD is correlated to the price of commodities, I'm not so sure that this is because of Canadian dollar strength, as compared to US dollar weakness.

I've been thinking about this, and I'm not sure that this distinction really matters that much. To a reasonably good approximation, the US *is* the Rest of the World.

Kosta: While clearly CAD/USD is correlated to the price of commodities, I'm not so sure that this is because of Canadian dollar strength, as compared to US dollar weakness.

Stephen: I've been thinking about this, and I'm not sure that this distinction really matters that much. To a reasonably good approximation, the US *is* the Rest of the World.

I mostly agree with you Stephen, from Canada's exchange rate perspective the vast majority of trade is in CAD/USD. So it doesn't really matter whether CAD appreciates or USD depreciates, the net effect is the same.

Then when considering exchange rate appreciation in lieu of interest rate increases, it again doesn't matter whether CAD appreciates or USD depreciates, but only that CAD/USD increases, at least at the first iteration.

But at the second iteration, it might be important whether CAD increases or USD decreases. Knowing which currency is moving would be helpful in predicting the future exchange rate path.

For instance, consider the recovery in Nick's model http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/03/the-division-of-labour-between-interest-rate-and-exchange-rate.html

Consider the point where the Canadian economy has stopped outperforming the US economy and that a US recovery is imminent. In Nicks' model, CAD/USD has appreciated and is about to start depreciating. Nick's model, if I understand it correctly, calls for the BoC to raise interest rates which would stop the depreciation of CAD/USD in addition to preventing the economy from overheating.

But let's think about why CAD/USD has appreciated to this point? Potentially it is because commodity prices have increased, increasing Canada's terms of trade, which increases CAD. Alternatively, it's because USD has depreciated as the US economic recovery has lagged.

Now if the US economy now recovers, it is likely that commodity prices will by buoyed by the additional economic activity coming from south of the border. It is also very likely that Canada's terms of trade will increase as the US imports more goods from Canada. It is also very likely that USD will appreciate as the US recovery takes hold.

If CAD/USD is driven by commodity prices and the terms of trade, then one would expect the currency pair to appreciate as the US economy recovers and demand for Canadian commodities, particularly oil, increases. But if CAD/USD is driven by the US dollar, then one would expect the currency pair to depreciate as the US economy recovers.

According to Nick's model, the expected and actual movement of the currency pair should affect the BoC decisions on interest rates. It could be important to assess whether CAD/USD will follow commodity prices as the US economy recovers.

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